Seigniorage transfers and runs on common currencies

Two identical countries A and B share a common (paper) currency C. The demand for currency is 5% of annual (Nominal) GDP.

Suppose B decides to quit the currency union and print its own currency. There are two different ways it could do this:

1. Convert and destroy. The people in B convert their C notes into their government's newly-printed B notes, and their government then destroys the C notes it has collected. The two countries carry on as before.

2. Print and spend. The people in B convert their C notes into B notes, and their government spends the C notes in country A. Or the government in B prints and spends the new B notes, and the people in B spend their unwanted C notes in country A. ("Spend" could include buying assets, including financial assets, and not just spending on newly-produced goods). Either country A now faces a doubling of the price level, which imposes a 5% of NGDP inflation tax on the people of country A, or else the government in country A increases taxes or sells assets worth 5% of GDP to prevent the supply of currency doubling.

By following the "print and spend" option, instead of the "convert and destroy" option, country B imposes a one-time tax of 5% of annual GDP on country A.

I haven't been following their disagreement very closely, but I think I'm agreeing with Hans-Werner Sinn and disagreeing with Karl Whelan. Institutional details like Target2 just encloud what is at root a very simple story.

It is extremely unlikely that the government of a country like Greece, in current circumstances, would follow anything like "convert and destroy".

But Greece is a small country, and 5% of a small country's NGDP is an even smaller percentage of a bigger country's NGDP. And it will be an even smaller percentage if Greeks continue to hold Euros as well as Drachmas. But magnitudes aside, it has the same effect as one more default.

If country A suspects that country B is planning to follow a "print and spend" exit from the common currency, it might want to jump ship first, so it is country B that makes the transfer to country A. There are incentives for a "currency run" at the supra-national level. Last one left holding the common currency is the sucker.

Of course, if there is initially a recession caused by an excess demand for the medium of exchange, there's a silver lining in all this "excess supply" of currency.

Comments

[Mike Sproul]

If the people in B had 100 C notes, they must have gotten them by giving bonds worth 100 C notes to the central bank of the (former) currency union, so the government of B wouldn't destroy the 100 C notes it collected. It would redeem them at the central bank for the 100 C notes worth of bonds it had previously paid to the central bank.

[Ro]

If B's money printing results in stimulus of presently idle productive capacity in country A, there is no "inflation tax." Just an increase in overall spending levels in country B, recorded as net positive claims on an increased amount of productive output in country A. Essentially South-to-North FDI. Win-win.

[JKH]

It all depends on how the various pieces of the Greek central bank balance sheet (which is part of the Euro system of central bank balance sheets) are resolved in the transition to a new stand-alone central bank balance sheet in a post exit scenario (where it is obviously not part of that system).

Nobody's even talking about that, but Sinn is right that resolution of the existing Target2 liability matters a lot.

[Max]

You're overlooking that by leaving the euro, Greece would forfeit its part ownership of the ECB. The last country to leave the euro would presumably own 100% of the ECB. Perhaps the details haven't been worked out in advance, but this is the only thing that makes sense.

Now there's one detail that complicates this logic. Greece is indebted to the ECB. If it defaults, the ECB can recover its loss by withholding dividends to Greece. So under these circumstances, Greece has less to lose by leaving the euro.

[JKH]

I'm not overlooking that at all.

The Greek participation in Eurosystem seigniorage is based on the Greek central bank capital key - not on the actual balance sheet structure or its own profit results. The same point applies to the marginal effect of issuing banknotes, where there is a sharing formula based on the capital key.

The fact remains that the German banking system is funding the Greek banking system through Target2.

This is an issue particularly if Greece just walks away from the principal amount of that funding liability - in addition to the rest of its default fallout.

[Jussi]

Coppola had a interesting and good post on this. I have a different point of view and thus kind of disagree but I think it depends how we view the union in the first place:

http://coppolacomment.blogspot.fi/2015/06/oh-dear-professor-sinn.html

[Nick Rowe]

Mike: Let's see:

In the beginning, the government of B wrote "IOU 100 C notes" on a bit of paper, gave it to the Bank of C, and the BoC gave the government of B 100 C notes in exchange. (The government of A does the same.)

Under "Convert and Destroy": the government of B prints 100 B notes, gives them to its people in exchange for the 100 C notes they hold, and gives the BoC those 100 C notes in exchange for the IOU for 100 C notes held by the BoC. The BoC then burns those 100 C notes, and the government of B burns the IOU. Everything carries on as before.

Under "Print and Spend": the government (or people) of B spends those 100 C notes in country A. And when the BoC asks the government of B to honour its IOU for 100 C notes, the government of B tells the BoC to get stuffed. [Update: in which case, the BoC has 200 C notes in liabilities, and only 100 C notes in assets, so the government of A will need to give the BoC an extra 100 C notes in IOUs as a freebie, to prevent inflation, according to Mike's Backing Theory.]

I think that's right.

[Nick Rowe]

In my above comment, I'm trying to translate what I said in Quantity Theoretic language into Mike's Backing Theoretic language. I think (in this case) we get the same outcome in either language (if I did the translation right).

[Min]

In the 1690s the Massachusetts colony began printing and coining its own currency. The main reason is that they were strapped for cash. Not enough British currency was circulating in the colonies, which is one reason why the Spanish dollar was a major currency here. The British Crown told them to stop or be charged with treason, as sovereignty belonged to the crown. Was the Massachusetts currency effectively a tax on Britain?

In lawyerly fashion Massachusetts starting issuing IOUs which it would accept in payment of taxes, effectively creating a fiat currency without calling it one. Was that a tax on Britain?

Later other colonies began issuing their own fiat currencies. The result was an increase in economic activity in the colonies, and general prosperity. Were those also taxes on Britain?

In times of insufficient money local currencies have proven to be effective without the local inhabitants destroying whatever other money they had. Businesses issue coupons, savings stamps, airline miles, credit card points. Are all of these in effect taxation on those who do not receive these benefits?

There is no question that there is not enough money circulating in Greece. The so-called bailouts of recent years went mostly to French and German banks. Under such circumstances would the creation of more money in Greece effectively be a tax on other Euro countries?

[Nick Rowe]

Ro and Min: that's what I meant by my "silver lining" sentence at the very end.

[Nick Rowe]

Jussi: I had a skim of Frances C's post, but her accounting and institutional detail is too complicated for little old me. I think we need to start with a very simple example, like my QT example, or Mike's BT example, look at the two possible outcomes, and then try to decide which of those two possibilities is closest to actual Greece.

[Nick Rowe]

Now I've got the Stooges' Search and Destroy stuck in my head.

[Nick Rowe]

I think I'm agreeing with JKH.

[Jussi]

Nick, I think the most important take away (aside of thorough technicalities) from Frances is that if Euroarea were a real currency union it wouldn't even record T2-balances. She didn't try to defy account, i.e. basis of QT / BT interpretation, which I agree is a useful way to start thinking about the effects. Maybe it was actually off-topic but, IMO, interesting point of view anyway.

"B prints 100 B notes, gives them to its people in exchange for the 100 C notes they hold, and gives the BoC those 100 C notes in exchange for the IOU for 100 C notes held by the BoC."

I think that's right and from BT's point of view it doesn't make a difference in terms of price level whether B defaults its bond owned by the BoC or B prints and spends as you described.
But Is there a reverse QT translation how B defaulting bonds owned by A's central bank will change A's price level!?

It doesn't make sense to pay back part and simultaneously default other part of existing debt. I vote 'print and spend'.

[Nick Rowe]

Jussi: it was definitely on-topic.

"...from Frances is that if Euroarea were a real currency union it wouldn't even record T2-balances."

I think that relates to the discussion between me and Mike above. Mike's approach looks at the assets (and liabilities) on the central bank's balance sheet, while my approach sets them aside. But I think I have shown above that we get to basically the same answer either way, as long as we do it consistently. What I wonder (this is pure speculation) is whether Frances C has switched between those two approaches halfway though.

[Roger Sparks]

There is another possibility.

I think a critical mechanical question is "Who backed the currency recently issued to Greek citizens?". According to wiki, all currency is labeled with the name of the issuing nation, encoded into the serial number. https://en.wikipedia.org/wiki/Euro_banknotes

Greek issued currency will have a "Y" as the initial letter in the serial number. In addition, "The remaining 11 characters are numbers which, when their digital root is calculated, give a checksum also particular to that country." (from the above link).

It seems to me that if a link to a Greek backed account (or currency issue) can be found, each Greek monetary unit may be potentially discounted. Of course, such a discounting would be laborious but if a link exists, it can be followed.

As another commentator said (in a comment on a Coppola post), any effort to follow euro national issuance would be destructive to the euro goals. Unfortunately, we are in unusual times and unusual things are occurring.

[Nick Rowe]

Roger: Let's just assume that the Y notes are indeed the liability of the government of Greece, and get separated out. If they become worthless, then that is the form the inflation tax would take under "print and spend".

[Roger Sparks]

If the Wikipedia article is correct ( https://en.wikipedia.org/wiki/Euro_banknotes ) then all currency presently in use is labeled. If correct, Greece is presently printing it's own currency. The euro union is a mechanism attempting to assign a common value to one unit (the euro) which can be accepted no matter which nation issued the currency.

It seems to me that euro deposits held in banks would be harder to identify in terms of nation of issue. Obviously, Greek banks would be suspect. Deposit holders with Greek addresses could also be suspect.

Someone is likely to lose money with any Greek default. Who will these unfortunate people be and will the losses be limited to bank holders?

[JKH]

Frances' main point seems to have been to reject Sinn’s interpretation of Target2 liabilities. She’s wrong on that particular point and he’s right, IMO.

A “real currency union” is a non-idea. There is no set architecture. The fact that the Eurozone fails on fiscal design doesn’t mean it’s not a currency union.

The Euro system includes a set of countries, each with its own banking system and its own central bank. The various national central banks take their policy marching orders from the ECB, which also has its own separate balance sheet.

The fact is that with a 100 billion Target2 liability, the Greek banking system is overdraft to the rest of the Euro system. That overdraft has been “plugged” by ELA loans to Greek banks. This is really just a fancy device in effect for recognizing the funding aspect of an overdraft in the first place.

There is a clear analogy with a single commercial banking system such as Canada's.

If a depositor at BMO takes his money to Royal, and nothing else happens, BMO is overdraft in its Bank of Canada account. Royal has a surplus reserve position. The Bank of Canada will “plug” that BMO overdraft with a formal advance.

If a depositor at a Greek bank wires his money to Germany, and nothing else happens, the Greek bank is overdraft at the Bank of Greece and the Bank of Greece is overdraft at the Target2 clearing system. The Greek commercial bank has lost deposits (a liability) and the Greek central bank has lost reserves (a liability). A bank in Germany has a surplus position in deposits (an asset) with the Bundesbank, and the Bundesbank has a surplus position in Target2 balances (an asset) at Target2.

The German banking system is funding the Greek banking system in this situation, via the Target2 clearing system. It is analogous to the example where the Royal is funding BMO – at the margin - via the Bank of Canada clearing system.

The Greek central bank has lost reserves (a liability) to another banking system; BMO has lost a deposit (a liability) to another bank. In both cases, there is a risk sharing procedure embedded in the rules for the clearing system, which stands between the two counterparties that created the effect.

These are both currency unions.

Germany’s Target2 surplus position is not “funny money” – any more than the Royal’s surplus at the Bank of Canada is “funny money”. It is funding provided from Germany to Greece via Target 2 in that example. Unless Greece can cover its deficit with private sector funding, it is being funded by Germany at the margin. And unless the BMO can cover its deficit with private sector funding, it is being funded by the Royal Bank - at the margin in this example - via the Bank of Canada.

The difference lies in the operating expectation for such coverage according to the rules.

The Bank of Canada wouldn’t take kindly to persistent BMO short position. The Eurozone is more tolerable – provided that the system continues to operate for all participants. Target2 exposures are formally open ended.

But that must change if the participant “leaves” the system.

If BMO “left” the Canadian banking system and declared its own currency, there would be a considerable clean-up operation required with respect to its Bank of Canada short position in Canadian dollars. It owes that money to the rest of the system. And the Royal doesn’t want to be told it has to “write off” the value of its surplus reserve position.

Neither does Germany want to be told something similar. If Greece leaves, that sort of cleanup is required. It owes that money – in Euros – to the rest of the Euro system. It is not “funny money” at that point or at any other point.

That is Sinn’s point on Target2.

[Nick Rowe]

JKH: your good analogy clarifies things for me.

(I edited it very slightly to put the apostrophe in France's in the right place, because that threw me momentarily, when I thought you were talking about the country!)

[Tom Brown]

Is there a way to frame what is happening with Greece as a natural experiment to either validate or invalidate different macro models? For example, are there some possible outcomes that would be consistent with monetarist models but inconsistent with new Keynesian models (or vice versa)? If so, any examples?

[Nick Rowe]

Tom: for a good natural experiment, you need some sort of random exogenous shock (or, a shock that was unrelated to any other economic variables that might also affect what happens). That doesn't seem plausible for Greece. It was no accident it happens in Greece first. And I don't see any massive disagreement between monetarists and New Keynesians on what will happen. Our own uncertainties are bigger than any differences. Our projections overlap theirs.

[Nick Rowe]

JKH: my own approach (in the post) was *consistently* funny money all the way through. My translation of Mike's point in comments above was *consistently* serious money (backed money) all the way through. In both cases we get the same two answers, with the second answer much more likely for Greece. Your own approach is *consistently* serious money all the way through, and you too get the same two answers, with the second answer more likely for Greece.

I am now more suspicious that Frances *may* be switching back and forth between funny and serious money.

[Jussi]

"Mike's approach looks at the assets (and liabilities) on the central bank's balance sheet, while my approach sets them aside. But I think I have shown above that we get to basically the same answer either way, as long as we do it consistently."

I agree and it is a good catch.

But I think from BT's point of view both sides of the CB's balance sheet are important. QT seems to be only about liability side, yet in this example you was able to reconcile both views when there was a loss in (A's) liability side (B defaulted a bond on A's balance sheet). Can there be even more common ground that?

***

I agree with JKH/Sinn - in theory and from accounting point of view.

"A “real currency union” is a non-idea".

Yes, I agree but it was just a quick comment - my waste of space not Frances's.

But I *think* the heart of the question is that Frances had a different interpretation of the currency area than Sinn. And it is IMO related whether the currency area can be viewed "real" in the sense that it is indeed deemed as irreversible - as for instance Draghi is repeating.

My interpretation of an irreversible is that given certain economic qualities, apart from optimum currency area, there needs to be certain functions (like fiscal transfers) in place such that the currency area can be expected to survive through economical and political cycles. On other words there is a set of conditions an irreversible less than optimum currency area needs to fulfill. This is vague but I think most of us agree that gold standard didn't work - Euro is similar in many ways and now has similar symptoms. I think given Europe less than ideal mobility, fiscal transfers are needed, even more than in the US.

Nothing above is meant to refute JKH's observation that "There is no set architecture" for a currency area. Yes, but can we view all the architectures as irreversible?

Given above I think Euro design with the targer2 balances, if not taken as symbolic, cannot be viewed as irreversible currency area. It will be just a reversible peg between sovereigns without real commitment and trust. If that was Frances idea in broad terms, I agree with her.

Anyway, I would emphasis that all the interpretations are mine not hers. Go and read her post(s).

[Jussi]

Above:

"... (A's) liability side (B defaulted a bond on A's balance sheet)."

Should be:

"... (A's) asset side (B defaulted a bond on A's balance sheet)."

[Max]

JKH, sorry, I was replying to Nick.

In Nick's hypothetical, country B would initially be entitled to 50% of the union central bank's dividends. After leaving, it's entitled to 0%, but gets 100% of its national central bank's dividends. It's a wash.

[JP Koning]

"It is extremely unlikely that the government of a country like Greece, in current circumstances, would follow anything like "convert and destroy"."

Why's that? If Greece is going to default on its IMF loans, why not default on its Target2 balances owing too?

[Nick Rowe]

JP: "convert and destroy", when translated, means Greece would honour its Target2 liabilities.

Max: (I misunderstood too). That bit is indeed a wash. But the one-time transfer of 5% of GDP (under "print and spend") is over and above that.

[JP Koning]

Right, understood. Good post.

[Max]

Nick: assume for simplicity that the central bank operates with zero capital, assets=liabilities. When the union dissolves, the central bank sells half its assets (which destroys half the currency), and cuts its dividends in half. But Country A then will receive 100% of the dividends, rather than the 50% it was receiving before. No change in wealth.

If the central bank's assets consist of equal parts Country A and B treasury bonds, and Country B exits AND defaults, then yes, the leaving country would benefit.

[Nick Rowe]

Max: OK. And then country B sets up a new central bank, which sells B currency in exchange for the bonds the BoC sold to the public. It's exactly like "convert and destroy", except the BoC did half of the converting and destroying.

[Redwood Rhiadra]

What happens if the ECB basically repudiates all Greek euros? Declares that it will not accept any Euro bill printed by Greece, and that all post-Grexit euro transfers from Greek banks to non-Greek banks/entities will be discounted by however much the drachma has depreciated since Grexit. This would essentially force the convert-and-destroy option, wouldn't it? (If country B can't spend its C notes/deposits at par, then they are effectively the same as B's new currency, as far as the outside world is concerned. And given that, B's citizens will quickly treat any remaining C notes/deposits the same way.) The only remaining "true euro" currency in Greece would be those physical notes which had migrated into the country previous to Grexit.

[Jussi]

"it will not accept any Euro bill printed by Greece"

This is interesting thought experiment but you have to remember that most of euros printed *in* Greece are already somewhere else. It would be complicated too in many ways. A lot of money has already ran away. It would create a horrible precedent.

One should keep in mind there is no such thing as a "bill printed by Greece", only a bill printed in Greece as a liability of the ECB and euro system as a whole.

"This would essentially force the convert-and-destroy option"

I don't think so, it would penalize some currency / deposit holders in Greece (and elsewhere) but it wouldn't match to the amount of liabilities Greece and Bank of Greece could default. In Nick's model the whole amount of C notes, not just the discounted amount, should be written off before A wouldn't be affected.

[Jussi]

"the whole amount of C notes, not just the discounted amount, should be written off before A wouldn't be affected."

Should be:

"the whole amount of C notes owned by the country B, not just the discounted amount, should be written off before A wouldn't be affected."

[Jacques René Giguère]

Nick: France Coppola's post explain why I tell my macro students that one of the two or three concepts they must master, if necessary at the expense of everything else, is the balance of payments.
In the canadian context, can you imagine the political consequences if the designers of the equalization payments system had decided to create an interprovincial set of accounts similar to Target2 instead of routing it through the federal budget? It would have all the Target 2 system' defects, including not taking into account the cause of the imbalance (misaligned exchange rates.) Recriminations are already loud enough.

[Mike Sproul]

Nick:
Your "convert and destroy" scenario sounds right, but then under "print and spend" you say:

"the government of B tells the BoC to get stuffed"

This creates a whole bunch of variables, and a whole bunch of scenarios. Maybe B tells BoC to get stuffed before B tries to spend its BoC notes in A, or maybe the BoC notes issued for B's bonds have an identifying letter "Y" on them, and people value them according to their estimation of B's financial health.

Let's focus on the "print and spend" scenario as you originally stated it, which did not mention anything about getting stuffed (not explicitly anyway).

The government of B could only issue B notes if it had assets to cover them (bonds issued by IBM, let's say). So there are 200 C notes (all held in country A) backed by bonds worth 200 C notes, and 100 B notes, backed by IBM bonds worth 100 C notes, so no inflation. But assuming the public desires real balances of only 200 C notes, 100 notes must reflux to their issuer.

[Jussi]

"Recriminations are already loud enough."

It does matter whether target2 claims are recorded only as a continuum of pre-euro style of accounting or are they recorded for an anticipated break-up?

I think Frances was saying, and I agree, we should mind the political commitment - Euro was meant to be irreversible. Thus target2 claims are just a bizarre accounting convention to be ignored. The claims are not funny money but should be accounted as a common liabilities.

[JKH]

The notion of “irreversibility” seems oxymoronic in context – apparently Grexit is imaginable.

There is a question of a legacy balance sheet for a central bank participant whose sovereign connection has abandoned the multi-central bank system and proceeded to set up its own currency and its own independent central banking operations. The lawyers would be all over the question of how to deal with that legacy balance sheet – who “owns” it (e.g. Greece or the ex-Greece Euro system) and according to what conversional/transitional financial adjustments?

The fact is that currency C now becomes a foreign currency for country B. And for example just to be able to redeem currency from the legacy balance sheet, B has to be able to credit commercial bank accounts with deposits in currency C – deposit accounts that can no longer be considered to be regular reserve accounts in the Euro system. They become nostro accounts in a foreign exchange system. That’s just for starters.

It gets very messy. To shrink that legacy balance sheet, assets must be sold/matured in order to generate the Euros to shrink the liability side. This is consistent with the BT view – which seems more fact than view.

One possibility might be to wind up the entire Greek NCB balance sheet and move it over to the ECB balance sheet as a legacy position there. But a valuation must be put on it (by lawyers and accountants) in order to do that. It becomes a question of who owes whom in completing that sort of transaction. Both the Target2 liability and the currency liability must be taken into account and covered by either the value of the associated asset transfer or by an additional debt of Greece to the Euro system if asset coverage for those liabilities is inadequate.

I don’t think the Target2 system is bizarre. It is merely a clearing system for multiple central banks who are exposed to losing or gaining reserve liability positions against each other (analogous to multiple commercial banks with the same exposure in deposit liabilities via a single central bank). It is a necessity for clearing operations in that multiple central bank context – which is quite separate from the consideration of fiscal arrangements beyond that. The only reason Canada doesn’t have such a system is that each province does not have its own central bank.

[JKH]

Nick -

sorry for the institutional/accounting thickets

remember Arte Johnson playing the German solder on "Rowan and Martin's Laugh-In" ?

"very interesting"

[Nick Rowe]

JKH: "The only reason Canada doesn’t have such a system is that each province does not have its own central bank."

Minor addendum. Following your initial analogy. In a sense, Canada does have one. It's just that nobody bothers to aggregate the data provincially. Suppose BMO has branches in all provinces. Suppose the depositors in PEI have negative balances, and those in other provinces have positive balances. If BMO gets wound up (or if the people in PEI decide they want to switch to another bank), the people in PEI can't just walk away from those negative balances.

Or, suppose that Canadian Banks were restricted to operating in one province only. If BNS had a negative balance on the books of the BoC, that would be like Greece on Target2.

[Nick Rowe]

JKH: this is a case where I really like you wading through those institutional/accounting thickets. So I don't have to even try (and get it wrong)!

Arte Johnson in that role was second only to Goldie Hawn, to my teenage mind.

[JKH]

Nick,

And the chartered banks have the flexibility to configure their internal management accounting to depict asset-liability mismatches by province of domicile – probably to the point of determining daily clearing results and mismatch changes by province if that were desired.

But even chartered banks have centralized fiscal operations.

[JKH]

good post by JP Koning:

http://jpkoning.blogspot.ca/2015/06/euros-without-eurozone.html

[Nick Rowe]

Yep: I was wondering how to put JP and Warren Mosler's business cards together.

[Jussi]

Thanks JKH, well explained.

I have got an impression that NCBs (and thus their assets) are "owned" by the respective member state and thus distribute their profits to their member state. But they are also a part of the Euro system being owner/equity holders of the ECB (https://en.wikipedia.org/wiki/European_Central_Bank). So Nick is, IMO, right about the last one being the sucker.

"The notion of “irreversibility” seems oxymoronic in context – apparently Grexit is imaginable."

I think “irreversibility” should be seen as a part of political rhetoric - as a strong commitment to keep all the member states on board. I see contradiction between extra layer of accounting which counts everything to a penny between member states and the idea of irreversibility. Given political commitment and perpetual nature of the target2 claims I think we should view them as common liabilities.

I think the following is true (JKH?):

The flows incurring target2 claims (by quadruple-entry accounting and all) are typically deposit transactions between private entities (e.g. transaction from Greece to Germany). Deposits are *common* liabilities of the whole Euro system. If the private cross-border transaction incurs forceable target2 claims it seems that Euro deposits doesn't in all cases offer a way to make true final payment? In other words in the Euro system a citizen might need to pay the cross-border payment twice, first as a private transaction and second time through taxes intended to cover target2 claims in the case of break-up?

[Oliver]

The Greek central bank has lost reserves (a liability) to another banking system; BMO has lost a deposit (a liability) to another bank. In both cases, there is a risk sharing procedure embedded in the rules for the clearing system, which stands between the two counterparties that created the effect.

Shared risk means that the burden of a fallout would have to be shared, too.

But you write It owes that money – in Euros – to the rest of the Euro system, which implies that the burden lies only with the party that leaves the system. Hans-Werner, is that you?

The Bank of Canada wouldn’t take kindly to persistent BMO short position. The Eurozone is more tolerable – provided that the system continues to operate for all participants. Target2 exposures are formally open ended.
But that must change if the participant “leaves” the system.
The bank of Canada also has clearly defined measures it can take to limit system imbalances whereas within the Eurozone, as you state, no such formal steps were defined (?). Nor do the national central banks have any power to counter ouflows, say with an independent monetary policy. Formally open ended is a euphemism for: do whatever you want, it doesn't matter, nor can you do anything about it. And if it doesn't matter now, how can it matter later?
What strikes me about the Euro construction is that you have a completely shackled national entity (NCBs) stuck in between a layer of supranational technocracy with a one-dimensional mandate (ECB) and private commercial banks that lack unified oversight and a unified legal foundation.
The hope, I suspect, was that the convergence criteria of the stability and growth pact would eliminate the possibility of asymmetric shocks happening in the first place. It's been a long time since I've herad anybody use the term convergence criteria to describe the Euro system. I wonder why...
I guess Coppola's idea of a 'real' currency union is one in which cross border controls are not even recorded (because there aren't any national central banks nor are banks registered with a nation state) and so cannot be claimed when a nation leaves the system. Nations and banks are completely separate entities. Upon leaving, the newly formed nation just gets back its original buy-in at the central bank and converts all other assets and liabilites on the books of whichever banks happen to join in into the new currency. They could all stay within the Eurozone but would have to set up headquarters outside of Greece, I guess. Not sure whether that's technically possible. It's certainly not how the Euro system is set up now. But I think Coppola is trying to say that a 'real' currency union should be thought of that way.

[JKH]

Jussi,

Roughly speaking, there is a sharing of aggregate Eurozone NCB financial results according to capital contributions by country. It is not a direct contribution from each NCB to its respective country treasury. It is risk sharing instead.

The answer to the last point depends on the mechanics of balance sheet resolution. The assets of a legacy position would be available to pay off the liability position that includes Target2. A key point is that an ex-Greece Eurozone going forward would have no interest in retaining a legacy position that includes loans to Greek banks and funding from the rest of the Eurozone. It would want to see resolution and repayment of those loans so that it has no Greek lending on the balance sheet, and consequent repayment of the Target2 position. A similar point applies to Euro currency issued from the legacy balance sheet, although the resolution of that also depends on currency redemption coming in. Rather messy.

An interesting wrinkle is that the ELA loans to the Greek banks are on the books of the Greek NCB but loans losses in this case are strictly for the account of Greece (a policy imposed by the ECB) - i.e. such losses will not be shared and are outside of the normal risk sharing formula for the Eurozone. That puts the Greek state on the hook for ensuring that an equivalent amount is available to repay those loans so that Target2 can be repaid to the rest of the Eurozone. That's one way that the balance sheet would imply a future tax liability as well. Of course, Greece supposedly has the option of defaulting on everything under the sun, including that Target2 liability.

[JKH]

I don't know what a "real" currency union is.

The United States?

Canada?

Since when did we start talking about those two as currency unions - other than since they started to be used as analogous and not so analogous comparisons with the Eurozone?

[Oliver]

To the extent that that's a reply to my point, you're right, of course. I was just trying to capture her spirit while agreeing with you, technically.

[Jacques René Giguère]

JKH: Canada and US are currency unions. Their regions have different economic cycles, different patterns of trade within and without the common currency area. If they had different currencies, their exchange rates would fluctuate.
We get around that with fiscal federalism in its many guises, both open and covert. Which is why few people ever noticed.
Neither chartered banks or official institutions compile a balance of payments between provinces or states,though researchers do it (PK frequently use them).
Thank God for the recriminations would be endless. In fact we have them in the form of who pays for equalization (forgetting why equalization is needed).

[JKH]

Jacques,

Thanks.

Actually, my question was an attempt to make a point of mootness about the definition.

To try and make it further, can you (or somebody) give me an example of a currency union consisting of two or more countries in which at least one of the countries doesn't not have its own operational central bank acting as a clearer for its own commercial banking system?

(e.g. the Eurozone does not fit with this qualification. Neither does Canada nor the United States.)

[JKH]

meant:

"in which at least one of the countries does not have"

[Jacques René Giguère]

JKH: I don't know enough about dollarized South American economies (Ecuador and Salvador).
An interesting aside : for a long time, the Caisses Populaires, the largest financial institution in Québec, could not clear their cheques though the BoC. They had to use a federally chartered bank do it. You could say that Québec didn't have its own central bank for clearing while in monetary union with Canada.
Are there here economic monetary history Ph.D connoisseurs of the Latin Monetary Union who could bring up their lights?

[Jacques René Giguère]

JKH: sorry. Not Salvador but Panama.

[JKH]

Jacques,

I don’t know how it works now, but when the foreign banks came into Canada in the early 1980’s as “Schedule B” banks, they each had to set up clearing accounts (reserve accounts essentially) with a Canadian chartered bank of their choice. The Bank of Canada farmed out that function to the chartered banks and the chartered banks competed for that foreign bank business. The somewhat imperfect analogy there was that each of the chartered banks operated as a central bank for its own group of foreign banks in the context of that foreign bank reserve clearing function. The Bank of Canada then played the role of the super central bank relative to those foreign commercial banks. Each chartered bank would experience a net clearing effect attributable to the aggregate of its foreign bank client clearers, which would be vaguely analogous to the Target2 clearings of the Eurozone - although that clearing effect was merely a subset of the total clearings of all of the bank’s customers.

[Oliver]

give me an example of a currency union consisting of two or more countries in which at least one of the countries doesn't not have its own operational central bank acting as a clearer for its own commercial banking system?

Is there any reason in your mind why that shouldn't work even if there is no historical example?

And do you know of currency unions between nations that have worked out? And if so, why?

Sorry, lots of questions. Just seems like we've chosen the worst of all possible systems here in Europe.

[Jussi]

"The answer to the last point depends on the mechanics of balance sheet resolution. The assets of a legacy position would be available to pay off the liability position that includes Target2. A key point is that an ex-Greece Eurozone going forward would have no interest in retaining a legacy position that includes loans to Greek banks and funding from the rest of the Eurozone. It would want to see resolution and repayment of those loans so that it has no Greek lending on the balance sheet, and consequent repayment of the Target2 position. A similar point applies to Euro currency issued from the legacy balance sheet, although the resolution of that also depends on currency redemption coming in. Rather messy."

Thanks JKH, well explained again. Yes, there are usually assets to cover the liabilities. But in case of Greece the cumulative negative balance of payments and depressed state of the economy means that there are not enough assets in aggregate level, thus ELA. But it is true that in resolution some of the liabilities can be covered by the assets.

I just feel that in a currency union a citizen should only be liable of his/her balance sheet not of his/her member states banks' aggregate. It just strikes bizarre to me. IMO this is against some very elementary characteristic of a currency union. The nature of liability after a deposit payment should be always the same and shouldn't depend whether they are cross-border or no, that is why we call it a union. And it shouldn't depend on the balance of payments or member state banking operations/balance sheets.

But on the other hand the Euro members are sovereigns - from that point of view the citizens should be on the hook for their respective government debts. But target2 claims are just a big heap without earmarks. Then this all is messy and complicated because of the chartered banking and sovereign connection with its banking sector / NCB. And as you said Greece can anyway default them all in if decides so. Messy indeed.

JP had an old post which is relevant:

http://jpkoning.blogspot.fi/2011/12/ecb-ncbs-collateral-capital-key-target2.html

(The post has the following quote:)

"The March 2011 Bundesbank report describes this:

'An actual loss will be incurred only if and when a Eurosystem counterparty defaults and the collateral it posted does not realise the full value of the collateralised refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it. The cost of such a loss would be shared among the national banks in line with the capital key.'"

If we take that on face value I think it is fair to say that Bundesbank, at the time, agreed that target2 shouldn't be borne by respective NCB.

"An interesting wrinkle is that the ELA loans to the Greek banks are on the books of the Greek NCB but loans losses in this case are strictly for the account of Greece (a policy imposed by the ECB) - i.e. such losses will not be shared and are outside of the normal risk sharing formula for the Eurozone. That puts the Greek state on the hook for ensuring that an equivalent amount is available to repay those loans so that Target2 can be repaid to the rest of the Eurozone. That's one way that the balance sheet would imply a future tax liability as well. Of course, Greece supposedly has the option of defaulting on everything under the sun, including that Target2 liability."

That comes to an interesting point of collateralization. I *think* collateral is posted and held at the NCBs on the behalf of the Euro system. This relates to the resolution - in normal operations the banks are posting their asset to the respective NCB against the target2 claims they are incurring.

But above means that ELA is not that different in the grand scheme of things - because even in normal liquidity operations target2 claims are not collateralized. So in the case of the break-up there is no factual economic difference what Greece can default whether respective target2 claims are generated by the ELA or through normal liquidity operations. From moral point of view though this might make a difference.

"Just seems like we've chosen the worst of all possible systems here in Europe."

There doens't seem to be political support for a better/workable (federal) system. It is rather telling how the Euro system has been set up.

[JKH]

Oliver,

My statement there was a bit convoluted.

Turn it around, and the question becomes:

Is there any country in the world with a single central bank issuing its own fiat currency that is not composed of different “regions” with different economic resources and needs? In that sense and in the previous context, every standard fiat currency issuer can be considered to be a currency union, and the definition becomes somewhat moot.

So my point is about language I guess. I think the Eurozone is a currency union, but an ineffective one because of fiscal dysfunction of one type or another.

[JKH]

Jussi,

“If we take that on face value I think it is fair to say that Bundesbank, at the time, agreed that target2 shouldn't be borne by respective NCB.”

I think that statement applies to the risk faced by an NCB in respect of Euro system counterparties to its asset holdings. And that’s fine so long as the NCB remains intact as a functioning part of the Euro system. Losses are absorbed according to risk sharing.

But that does not say that the Euro system will simply forget about the Target2 liability of an NCB that exits the Eurosystem.

At the time of exit, the NCB balance sheet will reflect the status of any cumulative losses as per the risk sharing formula to that point. But then the remaining balance sheet has to be resolved in some fashion.

I think the Target2 liability becomes a crystallized debt at that point – to be repaid or defaulted by the NCB or written off by the ECB.

Have a look at JP’s latest. I think he gets it right:

http://jpkoning.blogspot.ca/2015/06/euros-without-eurozone.html

[Jussi]

"I think that statement applies to the risk faced by an NCB in respect of Euro system counterparties to its asset holdings. And that’s fine so long as the NCB remains intact as a functioning part of the Euro system. Losses are absorbed according to risk sharing.

But that does not say that the Euro system will simply forget about the Target2 liability of an NCB that exits the Eurosystem."

Agreed (my interpretation wasn't accurate, thanks).

"At the time of exit, the NCB balance sheet will reflect the status of any cumulative losses as per the risk sharing formula to that point. But then the remaining balance sheet has to be resolved in some fashion."

I think I agree. The ELA is weird though, there are no assets against it, yet it is non-shared liability. So the NCB might end up with negative equity because of that?

"I think the Target2 liability becomes a crystallized debt at that point – to be repaid or defaulted by the NCB or written off by the ECB.

Have a look at JP’s latest. I think he gets it right:

http://jpkoning.blogspot.ca/2015/06/euros-without-eurozone.html"

Yes, I liked JP's post. And totally agree with it - as well as I think I also get the idea of "the contingent Target2 liability" (after reading Sinn 2011). I agree, from the system point of view, everything Sinn/you are saying.

But after reading Coppola, I think there is also different point of view beyond accounting if you will. The crux is that the way the Eurosystem was setup and now interpreted doesn't reflect the way it was sold and voted for at the inception of the Euro (and during). E.g. it didn't alleviate balance of payments crises - which given Sinn's view is quite obvious.

I think it comes clear if we ask why the issued currency (notes and coins) liability is recorded on balance sheets of the NCBs and yet the currency is clearly meant to be issued as a shared liability? There seems to be a stark contradiction: it was said it is the liability of the whole, yet it was booked as a liability of individual NCBs. In similar fashion I think we need to propagate the idea to target2 claims. If we put currency on the ECB balance sheet it would be really awkward/impossible to record target2 claims on NCBs balance sheets reflecting deposit payments. Would currency and deposits in all member countries even trade at par if they are treated differently as above.

If we acknowledge there is a discrepancy we have two different views, Sinn's view and, lets say, voters' view. So I repeat we need to acknowledge the political commitment - even if it contrast starkly the way the Eurosystem was set up. If we acknowledge this contrast it should have implications whether we can say without reservations that target2 claims need to be crystallized as debt if the balance sheets are to be resolved. That's all I'm saying.

[Jussi]

Three questions (anyone):

1. How the reconcile "immediate finality" (e.g. http://www.ecb.europa.eu/paym/t2/html/index.en.html) and the potential future tax liability Sinn's view is implying?

2. Given Sinn's view, what is the substantial difference from risk sharing point of view between the EMU and the Euro system?

3. And relating to that: in below quotations, what is the risk borne by the Eurosystem if not the one it faces at the time of exit? Or can a NCB get more equity (according the capital key) if it faces a loss on asset side?

"An actual loss will be incurred only if and when a Eurosystem counterparty defaults and the collateral it posted does not realise the full value of the collateralised refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it. The cost of such a loss would be shared among the national banks in line with the capital key."

[Roger Sparks]

Jussi,

These are three interesting questions. They all relate to risk; who takes the hit if there is a default?

First, some background framework: Target2 is a clearing system. It obviously must have the total balances for every participating member. This is useful information. We can collect all the banks in any nation and then analyse how the collective balance sheets grow over several years.

More framework: Banks within any country are extensions of the NCB. Because we know the balance sheet of each bank, we can sum up the implied balance sheet of each NCB. This gives us a measure of the relative obligations of each NCB. The Target2 information shows that German banks are accumulating euro credits and Greek banks are incurring euro debits.

Can we find answers to your three questions within this framework?

We will use an example of a German car sold to a Greek buyer. Assume that neither the car builder nor the car buyer have their own money; each must depend upon a bank loan to proceed. This will break down into a number of events:

1. The German car builder will get a loan from a bank. He will build a car and pay his workers. Money will be dispersed into the economy and will increase the amount of deposits in the Target2 (German) account.

2. The Greek buyer will get a loan and take possession of the car, wearing it out over a few years. Will the Greek buyer get the loan from a Greek bank or a German bank? Hmmmm.

2A. The Greek buyer may not need a loan. Perhaps he is a VERY well paid Greek government employee who pays cash. Unfortunately, the Greek government depends upon loans to fund VERY good wages. Does the Greek government borrow from Greek banks or from German banks? Hmmmm.

3. After several years, the cars are worn out. Loans only retire when paid or are defaulted upon.

I would say that "NO, we cannot find answers from this example." Instead, we see that the example provides many ways of shifting risk:

First, the real buyer of the initial car is the German Bank. Who is the risk taker here, the bank or the supporting government?

Second, the buyer may be take a loan OR his employer may take a loan. If the employer takes the loan, the risk of collateral loss (and normal depreciation) has shifted from the buyer to the employer (or the risk been effectively hidden).

The Target2 data seem to indicate that Greek employers are taking loans to buy German cars from German banks. Unfortunately, the cars are now worn out but the loans remain unpaid. Who will take the loss?

[Jussi]

1. The German car builder will get a loan from a bank. He will build a car and pay his workers. Money will be dispersed into the economy and will increase the amount of deposits in the Target2 (German) account.

Target2 will be incurred only if money is moved across German's border.

2. The Greek buyer will get a loan and take possession of the car, wearing it out over a few years. Will the Greek buyer get the loan from a Greek bank or a German bank? Hmmmm.

Yes, but I guess 99 % of the household loans are, still, within country. We can, IMO, assume this away. Yet in theory it blurs the picture. I think Sinn's view will be day by day harder to justify as more and more people will use accounts outside their home country.

2A. The Greek buyer may not need a loan. Perhaps he is a VERY well paid Greek government employee who pays cash. Unfortunately, the Greek government depends upon loans to fund VERY good wages. Does the Greek government borrow from Greek banks or from German banks? Hmmmm.

If the government issues a bond, I reckon the money will be always (necessarily, JKH?) summoned to local bank or a local branch of foreign bank. This will, AFAIK, incur credit on the respective governments Target2 account if it is receiving cross-border bank deposits as proceeds. But if the government then uses proceeds for cross-border payments the Target2 will be debited respectively.

[Jussi]

Adding to/editing 2A:

I think we need to keep in mind that moving deposit cross-border always has a Target2 reflection. So the governments might, and probably have, accounts in different member states (or even in other currency areas) but that doesn't change the picture much. The target2 keeps track where deposits are now relative to where they were created.

[Jacques René Giguère]

Given that Germany runs a current account surplus, no Greek bank can ultimately lend to buy a german car. Only a german bank can. And since the official policy of Germany is to run a permanent trade surplus, even that bank can't lend.
By having a trade surplus, Germany is refusing to be paid. Why should anyone repay debts for which the creditor refuses payment and threfore make it imoossible to pay?

[Oliver]

I think the Eurozone is a currency union, but an ineffective one because of fiscal dysfunction of one type or another.

Agreed. What interests me, or what I find interesting about Coppola's post, is the question whether, putting fiscal issues aside, there are different types of monetary unions. Or what does the term monetary union mean?

If one takes union to mean the abolition of borders, a monetary union must therefore be one in which all things related to the payments system are in effect supranational. The mere existence of target2 balances violates this principle, at least if it is strictly interpretated in the way Sinn does. Coppola proposes a liberal interpretation of the accounting facts to make it fit the above definition. But I fear, in the case of a Grexit, Sinn and you are right in that such a liberal interpretation would not stand a chance.

A valid question is also, whether such a setup would funtion better in normal times and whether the exit of a member would be render different results. We'll never know for sure, I guess.

In the end, the Euro system seems a bit like a marriage with separate estates, whereas to me personally the term union implies community of property. But target2 tells me the founders of the Euro thought otherwise.

[JKH]

Poor old Target2 just can’t get any respect.

In current circumstances, there has been a deposit outflow from the commercial banks of Greece to banks in other countries that take Euro deposits – mostly banks in the other Eurozone countries. The money flow associated with that deposit loss is recycled in effect by Target2 back to Greece – as a Target2 claim of the non-Greece Eurozone banking system on the Greek central bank (NCB), a claim that constitutes a balance sheet liability for the Greek NCB. It is in effect a form of funding, plugging the hole in the balance sheet that is left when Greek system reserves (issued by the Greek NCB as a liability) are debited to pay for the flow of funds from the Greek banking system to other banking systems.

The Greek NCB in addition then lends money to the Greek commercial banks through ELA, replacing the hole left in their balance sheets through the deposit loss. While the accounting may be awkward to explain, at the end of the day, the Greek NCB balance sheet expands with ELA assets and Target2 funding. It is a pass through of funding in this sense, with the Target2 system as the intermediary.

SUPPOSE the Eurozone banking system were structured in a different way. Suppose every commercial bank in the zone regardless of country domicile had a reserve account directly with the ECB. In other words, suppose there were no national central banks (NCBs), just the ECB.

Then consider today’s scenario in that structure.

The Greek deposit outflow that is now aggregated at around 100 billion Euros through Target2 would then consist of a number of funding shortages across various Greek commercial banks, resulting from their inability to replace deposit outflows through normal funding channels. Those funding shortages would show up first as reserve account overdrafts directly on the books of the ECB. And then, similar to the current use of ELA funding provided by the Greek NCB to the Greek commercial banks, the ECB would have provided similar funding to the Greek commercial banks directly from its own books.

But there would be no difference in terms of the fiscal characteristics of this crisis.

The only difference would be in the display of the aggregation or disaggregation of the various funding profiles for the Greek banking system. Target2 would simply vanish as a middle man for the recycling of aggregate Greek deposit outflows back to Greece. The ECB would be the pure middleman, without the NCBs or Target2.

So don’t blame poor old Target2. It’s just a facilitating clearing AND FUNDING system to accommodate funding aggregation at the level of the existing NCBs. No direct implication for the fiscal characteristics of the existing Eurozone architecture.

[Oliver]

Poor old Target2 just can’t get any respect.

:-)

I think I understand, thanks.

Btw, I wasn't implying fiscal consequences, merely national ones in the sense that data that was conveniently aggregated along national borders (target2) might influence the course of the impending bankrupcy procedure and would provide welcome fodder for divorce lawyers and the media alike.

But I guess even if banks were being directly funded by the ECB, a) considering banks are registered somewhere, one could still easily divide along national lines and b) a looming secession with banks remaining in their respective national as opposed to currency areas was always bound to be framed in national terms anyway. That's sort of the point of a nation exiting a currency area, I guess. It's a question of where you cut, not which data you collect.

Anyway, time to stop boring everyone with my musings.

[Ramanan]

Nice explanations by JKH.

The view "TARGET2 intra-ESCB liabilities are not really debt" can be shown to be inconsistent by various though experiments.

Here's the simplest.

Suppose the Greek NCB holds €10bn of German government bonds acquired because of various historic reasons. Now suppose the ECB buys these bonds worth €10bn from the Greek NCB. This happens via a reduction in the Greek NCB's liabilities via TARGET2 entry.

Greek residents have now less foreign assets as well as less foreign liabilities.

All well and good.

But according to those who argue that intra-ESCB liabilities shouldn't count as debt, Greek residents have lost an asset.

They cannot simultaneously claim that the intra-ESCB liability is not debt and that Greek net foreign assets are unchanged (in the above example).

[Jussi]

Ramanan / JKH,

We (always) agree(d) on the accounting side.

Would you mind to comment whether you see the problem (my question #1 above) that the Euro doesn't offer "immediate finality" as the ECB / politicians promised (e.g. here: http://www.ecb.europa.eu/paym/t2/html/index.en.html). I refer to the case where a Greek pays for a German car which incurs Target2 liability. If that liability is paid through taxes at the time of the break-up the Greek can be considered to pay his/her car twice. Or maybe the case is more glaring when the Greek's government pays it cross-border bills as they will end up being funded by the Bank of Greece Target2 liability. So a government payment creates at the same time a liability for the very same government, payable at the time of the break-up. Thanks.

[JKH]

Jussi,

If Greece leaves the Eurozone, it is natural to expect that the Target2 liability should be repaid to the ECB/residual Eurozone.

The Target2 liability is a liability of the existing Greek NCB.

If the Greek NCB balance sheet held assets of sufficient Euro value to cover that liability, and if those assets could be realized for that Euro value, then the T2 liability could be repaid from the balance sheet resources of the Greek NCB. This could be very problematic in fact due to the questionable quality and lack of liquidity in such assets. Then it becomes a higher order fiscal liability for Greece, given that it is in effect extracting its NCB from the Euro system.

This is not paying for the car twice. It is paying for the car, plus paying for what is effectively the Greek banking system’s liability in respect of the capital inflow (a capital account surplus) that resulted from buying the car as an import (the corresponding current account deficit). Looking through the transaction to the end points, it is buying the car in exchange for monetary assets of questionable value. Pay for the car first, and then later reimburse for the bad assets used to pay for the car.

[Jussi]

Thanks again JKH,

That was again agreed and a clear way to put it.

"Then it becomes a higher order fiscal liability for Greece, given that it is in effect extracting its NCB from the Euro system."

If the Eurosystem/Troika were ousting Greece, should the Eurosystem bear the (net) liabilities of the Bank of Greece? But if that is true then there are two ways of seeing how the resolution should be made (for the record I don't know who's the one to blame for the current mess)?

"it is buying the car in exchange for monetary assets of questionable value"

For me this goes against the very essence of the currency union. The Euros should represent the monetary assets, if questionable in value (as they are if losses are not shared), it compromise the value of the Euros. But I appreciate that with strong fiscal independence there is a moral hazard present if the above idea is not binding.

[Oliver]

@ Jussi & JKH

Just found this:

...Another issue which arises from the decentralised legal structure of TARGET 2 is the issue of TARGET balances which has been the subject of media comment over the last few years.

TARGET 2 balances are not foreseen to be settled. They are booking entries in CB balance sheets. Basically, for each euro issued in net terms, a Euro system national central bank (NCB) automatically generates a claim of the ECB on itself. However, no settlement at any horizon is attached to that claim, reflecting a principle of confidence within an integrated monetary area.

In the early years of TARGET 2, balances were not that significant but more recently, they have become material by any standard. Indeed, in mid-2012 they peaked at roughly 10 percent of euro area GDP. However, the statement sometimes made that they represent bilateral obligations between Eurosystem CBs is not correct except on an intraday basis.

The Governing Council of the ECB decided in 1999 that the bilateral balances should be netted on a daily basis by novation which was considered to be in line with the principle of an integrated monetary area. Consequently, with effect from 30 November 2000, the claims and liabilities related to TARGET ( TARGET 1 in those days ) have been netted by novation at the end of each TARGET day resulting in each Eurosystem CB having an obligation or claim towards the ECB with this concept being reflected in Article 6 of the TARGET 2 Guideline.



Whilst the Harmonised Conditions appended to the TARGET 2 Guideline address the issue of insolvency of a participant, understandably they do not envisage the failure of a Eurosystem central bank to honour its obligations. However, the theoretical case of an NCB leaving the Eurosystem and being unable to reimburse its TARGET liability has been described by Deutsche Bundesbank as follows “Should a country with TARGET liabilities opt to leave the euro area, any claims the ECB might have on the NCB of that country would initially persist in the same amount. If the exiting central bank proved unable to repay its liabilities despite loss-offsetting within the Eurosystem and the collateral available, it would be necessary to devise a solution for the outstanding amount. Only if and when a residual claim was deemed unrecoverable would the ECB actually recognise a loss by virtue of writing it off as a bad debt.” The ECB could then call on its shareholders – that is the central banks of the remaining euro area countries – to participate in the loss according to their shares in the ECB’s capital.

http://enews.ebf-fbe.eu/2014/01/who-said-payment-systems-are-simple-legal-issues-arising-from-the-structure-of-target-2/

[Oliver]

And regarding finality of payments and the double payment that Jussi mentioned, there is this, which I'm not quite sure what to make of. Maybe JKH can take a stab? Sorry about all the copy paste, but it would a much greater waste of webspace if I were to attempt to put it into my own words.

...we need to verify whether the European monetary union adopted a single currency indeed.

Though surprising, the answer is negative, the reason being the lack of payment finality between euro area member countries. The Trans-European Automated Real-time Gross-settlement Express Transfer (TARGET) system is managed by the central banks of the member countries, and the payments between countries (between their residents) are made through their central banks. In the absence of final payments between the member countries, through the agency of the ECB, national currencies are not yet made homogeneous. This means that, de facto, the switching to the monetary union has been purely nominal. Member countries of the euro area did not replace their national currencies with a single currency, but simply changed their currency’s name. Hence, different euros are circulating within each country within the monetary union. Therefore, we note the existence of a nonsensical situation, as countries abandoned their monetary sovereignty without really losing it.

http://www.quantum-macroeconomics.info/international-economics/

or this:

http://www.quantum-macroeconomics.info/Web_Site_Quantum/wp-content/uploads/2015/02/Schmitt-B.-2014-The-formation-of-sovereign-debt.-Diagnosis-and-remedy-Social-Science-Research-Network-SSRN.pdf

[Oliver]

And I'm not sure what Mr. Roger Jones, Chairman of the TARGET Working Group, whom I quoted @ 10:28 means when he says reflecting a principle of confidence. Seems to me keeping tabs indefinitely reflects the opposite of having confidence in each other. Or maybe it means that it reflects confidence that the system won't be put to a test?

[JKH]

Jussi,

“For me this goes against the very essence of the currency union.”

I agree.

But in fact there is no longer a currency union to which this principle applies.

I.e. no longer a currency union to which Greece belongs in this case.

The original car transaction and value given in Euros at the micro level is fine.

But if Greece leaves the union, there must be a macroeconomic settlement of previously incurred international intra-union financial claims.

Specifically, international capital account claims must be settled on the basis of Greece now no longer belonging to the union.

Looking through to the international macro accounts, the car was purchased with a Target2 liability.

That liability was OK as an indefinite position under the terms of the union.

But when Greece leaves the union, it is no longer OK as such an indefinite position. It becomes due. The ex-Greece union wants their money back.

See also my next comment to Oliver.

Oliver,

“Should a country with TARGET liabilities opt to leave the euro area, any claims the ECB might have on the NCB of that country would initially persist in the same amount. If the exiting central bank proved unable to repay its liabilities despite loss-offsetting within the Eurosystem and the collateral available, it would be necessary to devise a solution for the outstanding amount. Only if and when a residual claim was deemed unrecoverable would the ECB actually recognise a loss by virtue of writing it off as a bad debt.”

I hadn’t seen that, but that is what I’ve been saying.

The nature of a Target2 liability changes as the result of a transition from status quo going concern Eurozone membership to exit from that membership. A liability that was once tolerated as indefinite now becomes due.

(This is where Coppola’s anti-Sinn post was basically incorrect and where Sinn is correct.)

Oliver,

I think I’ll leave quantum macroeconomics to the quantum macroeconomic theorists.

:)

[Jussi]

JKH,

"But in fact there is no longer a currency union to which this principle applies."

Yes, I see the logic.

But enforcing the logic means that the Euros are not only backed by the central Bank assets but also with fiscal transfers in the case of the break-up. I'm not sure any country was agreeing to support the value of Euros by fiscal transfers. Yes, Greece broke fiscal packages / treaties but that doesn't mean they automatically have the contingent liability of the Target2 claims. That might be problematic from fiscal / monetary policy division point of view.

Contingent Target2 claims would also mean that deposit par pricing is tricky because there is always a positive probability for the break-up in the future. Also incentives are bizarre, basically people should always borrow money from the bank domiciled in other member country to avoid possible future tax liability.

If claims are not on any NCB the currency area is more solid and efficient.

Oliver, interesting texts, nice research :)

“Should a country with TARGET liabilities opt to leave the euro area, any claims the ECB might have on the NCB of that country would initially persist in the same amount. If the exiting central bank proved unable to repay its liabilities despite loss-offsetting within the Eurosystem and the collateral available, it would be necessary to devise a solution for the outstanding amount. Only if and when a residual claim was deemed unrecoverable would the ECB actually recognise a loss by virtue of writing it off as a bad debt.”

I read this as the Bundesbank (as also in its other quote) agrees that the liabilities of given NCB is limited to assets it holds. And anything beyond the assets should be covered by the ECB (and its owners on capital key basis) not by the respective member country.

[Oliver]

JKH
Yes, and I think everyone agrees with you. The question is, could it be different and would that make a difference?

Jussi
Thanks.
To rephrase your point, which I think I would agree with: for the Euro to be considered a single, homogenous currency, inter-country payments would have to be settled finally by the ECB through novation on their behalf, while excluding the possiblity of subrogating against any entities other than its own shareholders according to the predefined capital key. Does that make sense?

That obviously places a much higher burden on the ECB to homogenise the quality of what would then be a supranational banking system. But then, that is a minimum requirement for any functioning currency area, I would have thought.

More importantly, to the extent that the above is correct, it would also mean that the shortcomings of the Euro area are not solely its missing fiscal integration but also a monetary system which is still divided, if only contingently, along national borders.

As for quantums and quarks. I have no idea who came up with that daft name, but they are a formation of proto Post Keynesians around Bernard Schmitt (SSRN paper link) with proponents here in Switzerland, France and, I'm sorry to say, Canada (L. P. Rochon) :-). But, even after a couple of attemtps, I can't get my head around their concept of doubling of international debt. I tohught maybe someone wiser than myself could translate. It does have something to do with final settlement, though, which is why I brought it up.